BRENT: BEWARE THE BREAKOUT

Takeaway:Brent Oil is a potential fly in the #GrowthAccelerating ointment.

Brent Oil is dancing around our long-term tail-risk line of $108.36/barrel today. It broke out above it earlier in the session.

Our global macro model says $108.36 (or higher) is key. That is where we choke global consumption demand. Since U.S. consumption growth effectively doubled in the last six months to 2.4% vs. 1-1.2% prior, that’s a headwind, on the margin.

An expedited back-up in oil costs and the follow-on impact to fuel prices will be a headwind to other discretionary consumption growth. Gas prices aren’t yet a headwind (they are still lower on both a YoY and QoQ basis) but any existent tailwind is diminishing.

A large and sustained back-up in energy costs (at the same time as the furloughing of federal workers), while not a direct drag to disposable income growth, does serve as an incremental drag to consumption.

Bottom line: Rising Oil Prices is not a dynamic supportive of continued #GrowthAccelerating.

#RatesRising

Takeaway:Consumer Discretionary and Financials are where you want to be positioned.

This note was originally published July 09, 2013 at 15:07 in Macro

We’ll introduce our detailed view on #RatesRising and the cross-asset class implications of the reversal in the 30Y bull cycle in bonds on our 3Q13 Macro Themes call next Tuesday July 15th.

As a visual preview and for some historical context, the sector study below shows the average, relative Q/Q sector performance during periods in which the factor combination of: Rising 10Y Yields, Expanding Yield Spread, and $USD appreciation all prevailed. At n=7, the sample population isn’t overly large but we’d still view the output as instructive.

General underperformance in defensives and outperformance in cyclicals isn’t particularly surprising. Additionally, we’d note that given the policy catalyzed, positive relative performance in yield chase assets, the downside for sectors such as Utilities and Staples is likely larger than historical precedent would suggest.

Further, in the context of our #StrongDollar and Bearish China/Emerging Markets view, the relative performance risk for Materials and select Energy & Industrials is likely to the downside vs the historical mean.

In short, alongside continued TREND improvement in domestic Labor Market, Housing, Confidence and Credit metrics, we’re viewing the back-up in Treasury rates and expansion in the yield spread as a pro-growth signals.

In terms of positioning, the 1H13 playbook remains largely in-tact with Consumer Discretionary and Financials the best way to find positive $USD and domestic consumption leverage at the sector level. While equities are immediate-term overbought here (see today’s note: Overbought: SP500 Levels, Refreshed) we continue to like the absolute and relative growth setup for the U.S. and pro-growth oriented asset exposures.

CHINA WON’T STIMULATE UNLESS GROWTH FALLS OFF A CLIFF… IS THAT WHAT CONSENSUS WANTS?

We maintain conviction in our view that Chinese policymakers have no intention to meaningfully stimulate economic activity over the intermediate term – absent a “decrease [in economic growth] to the ‘lower limits’ set earlier” (according to Premier Li’s most recent commentary). The Party’s own economic rebalancing agenda, its preference for economic and social stability, accelerating property price inflation and a recent upside inflection in CPI all remain a headwind to monetary or fiscal easing.

Given that Chinese officials remain content to pursue slower, more sustainable rates of economic growth for the foreseeable future, we can’t help but anticipate a continuation of recent negative trends for Chinese equities, which continued to be pressured from a top-down (#EmergingOutflows) and bottom-up (structural banking sector headwinds) perspective.

With that in mind, don’t mistake the manic media’s interpretation and attempted explanation of today’s dead-cat bounces across Chinese equities and industrial metals as anything more than that. In fact, the Shanghai Composite Index can rally another +9% from here to its TREND line of resistance and our interpretation of the fundamental outlook for Chinese equities won’t have changed a bit.

In the immediate term, macro markets mean revert and we recommend having a tried and tested quantitative risk management process to properly interpret the price action. Over the intermediate-to-long term, however, macro markets tend to trend in the absence of a fundamental inflection(s) in economic gravity. With respect to Chinese stocks – specifically bank and property developer shares – we think that trend remains south.

To borrow and manipulate a quote from the late Rick James, “[monetary easing] is one helluva drug”. Indeed, it’s interesting to see yet another salty batch of Chinese growth data inflate consensus expectations of monetary and/or fiscal easing out of Chinese policymakers. Such has been the case for much of the past 18 months, despite Chinese equities and Chinese economic growth making-lower highs in the process.

Needless to say, we remain inclined to take the other side of such speculation.

Specifically, we maintain conviction in our view that Chinese policymakers have no intention to meaningfully stimulate economic activity over the intermediate term – absent a “decrease [in economic growth] to the ‘lower limits’ set earlier” (according to Premier Li’s most recent commentary). The Party’s own economic rebalancing agenda, its preference for economic and social stability, accelerating property price inflation and a recent upside inflection in CPI all remain a headwind to monetary or fiscal easing.

Explicitly in the 12th Five-year Plan and implicitly through their [in]action during the recent credit crunch Chinese officials remain content to pursue slower, more sustainable rates of economic growth for the foreseeable future. Heck, the Ministry of Finance actually just issued a country-wide directive for central government agencies to cut spending by an incremental 5% for 2013.

It should be noted that the Politburo, the PBoC and the State Council all came out at varying instances last week and talked down market expectations for GDP growth, credit expansion and/or monetary/fiscal easing going forward. Why some market participants appear content to ignore the data is beyond us:

President Xi Jinping said officials shouldn't be judged solely on their record in boosting GDP. He added, “the Communist Party should instead place more importance on achievements in improving people's livelihood, social development and environmental quality when evaluating the performance of officials”.

Premier Li Keqiang said the conditions for the Chinese economy to achieve its growth targets are [already] in place. Specifically, he noted that “conditions exist for China to realize its economic targets for this year and for sustainable, healthy development”.

PBoC Governor Zhou Xiaochuan affirmed our belief that the recent cash crunch was primarily caused by excessively rapid YTD credit expansion at some banks and was a timely reminder that many Chinese financial institutions need to adjust their businesses models. Specifically, he stated, “the PBoC refused to inject liquidity because it wanted the banks to adjust their practices, and the message has been correctly understood by the market”.

The State Council on Friday reiterated that it will maintain a prudent monetary policy to support economic restructuring. While it pushed back against requests from commercial lenders to loosen policy, it did note that credit growth will be kept at a reasonable level.

Just because we were largely on holiday last week doesn’t mean the Chinese economy took a vaca as well…

To play devil’s advocate and indulge the Pavlovian consensus hysteria, even if Chinese policymakers wanted to put the easing pedal to the metal, the law of large numbers rests as a meaningful roadblock for a material inflection in Chinese GDP growth (from our JUN ’12 note titled: “CHINA’S RATE CUT IS LIKELY A BAD SIGN OF WHAT LIES AHEAD”):

“… the 2008 stimulus package was CNY4 trillion or 12.7% of GDP at the time – that’s a fairly large hurdle to climb for an economy that is roughly ~50% larger in size (on a nominal basis) from its year-end 2008 level.”

In case “Pavlov” (i.e. consensus) is actually right for once and the PBoC does cut rates in the intermediate term – a highly improbable scenario based on Chinese OIS spreads – please note the title of the aforementioned research note and the fact that Chinese economic growth and Chinese equities continued trending down from the time of its publication until their respective inflections in late 2012.

Given that Chinese officials remain content to pursue slower, more sustainable rates of economic growth for the foreseeable future, we can’t help but anticipate a continuation of recent negative trends for Chinese equities, which continued to be pressured from a top-down (#EmergingOutflows) and bottom-up (structural banking sector headwinds) perspective.

With that in mind, don’t mistake the manic media’s interpretation and attempted explanation of today’s dead-cat bounces across Chinese equities and industrial metals as anything more than that. In fact, the Shanghai Composite Index can rally another +9% from here to its TREND line of resistance and our interpretation of the fundamental outlook for Chinese equities won’t have changed a bit.

In the immediate term, macro markets mean revert and we recommend having a tried and tested quantitative risk management process to properly interpret the price action. Over the intermediate-to-long term, however, macro markets tend to trend in the absence of a fundamental inflection(s) in economic gravity. With respect to Chinese stocks – specifically bank and property developer shares – we think that trend remains south.

Darius Dale

Senior Analyst

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07/10/13 11:54 AM EDT

WWW: Another Milestone to $100

Takeaway:2Q spot-on with our call that this is a $100 stock over 2-yrs. But we need some serious context around some overblown near-term factors.

This note was originally published July 09, 2013 at 13:30 in Retail

WWW's 2Q print was spot-on with what we needed to see to remain confident in our call that this is a $100 stock over 2-years. We think that the revenue hammer is cocked to add $1bn in sales over three years. This is accentuated by the margin story that reared its head meaningfully in 2Q and will get return on capital moving in the right direction after a 2-year decline.

One thing that became abundantly clear to us in listening to the conference call is how bifurcated the perception is on this name. We all know that Wall Street is naturally short-sighted, but easily 80% of the time on this marathon 80-minute call was allocated to near-term puts and takes that have no real bearing on what we think is relevant to the appropriate money-making thesis.

There were two factors in particular that were a big focus (and shouldn’t be). 1) The lack of guidance, and 2) Commentary around accretion of the PLG brands.

WWW bowed out of the quarterly earnings game, and simply reaffirmed an annual revenue range while upping annual EPS guidance by a dime after a $0.13 EPS beat Q2. Combined with unidentified/unauditable expenses that were supposedly pushed out, and unquantified revenue that was pulled forward, WWW succeeded in spooking the Street into keeping back half estimates low. We're at $2.86 vs. a consensus range for the year between $2.60-$2.75.

PLG Accretion. Here's one where we've got to call a spade a spade. Either the company's forecast accuracy as it relates to acquisition accretion is simply horrendous, or they've artfully sandbagged the Street's expectations on a consistent basis. Consider the progression of expected accretion/dilution vs. actual results. Going into the year, WWW guided to Modest Accretion in 1Q, Slight Dilution in 2Q, and $0.35-$0.50 per share in accretion for the year. It ended up earning $0.34ps and $0.24ps in 1Q and 2Q, respectively, from PLG, or $0.58 combined. Now, even though at the beginning of the year it called for accretion in both 3Q and 4Q, it is taking down expectations for zero back half accretion. Perhaps we'll fall victim to thinking there's a sandbag when one does not exist, but given the momentum of Sperry and Keds, we find it very difficult to get to a loss in 2H.

The near-term factor that mattered most, in our opinion, was the fact that the Performance division went from +8% in 1Q to -4.8% in 2Q. Simply put, Merrell, WWW's largest division, tanked. We can talk all day about how a product like M-Connect is up double digits, but the reality is that Merrell has a huge division called Outdoor Lifestyle that sells the non-performance product in the portfolio. We think that it was ignored immediately following the PLG acquisition, which is less than optimal given that it accounts for about 40% of the Merrell portfolio. The good news is that the company made organizational changes over the past 3-6 months, and the order backlog for the brand in aggregate turned up to the point where management noted that it can grow low single digits for the year. We have no reason to believe that they're lying about order levels, and the channel is lean enough that we don't forsee outsized cancellation levels. In other words, we're going to give them the benefit of the doubt on this one.

Even better is that the full benefit of the Merrell reorganization will be seen at the beginning of 2014, which is also when we start to see a greater impact from the company scaling Sperry and Keds over the existing International infrastructure. From a timing perspective, this is when we think people will really start to realize that WWW is much growthier than they otherwise think.

OUR THESIS

The Street is grossly underestimating the revenue growth opportunity as the legacy WWW scales its recently acquired brands over its global infrastructure. We think WWW can and will add $1bn in sales to its $2.7bn base over 3-years. Under its former owner, Sperry, Keds, Saucony and Stride-Rite only generated 5% of its sales outside of the US, and most of that was in Mexico and Canada. Legacy WWW, on the other hand, is the most global footwear company in the world (yes, even more so than NKE and AdiBok), with 65% of units sold outside the US through an elaborate network of seamlessly-integrated third-party distributors. Given that the infrastructure is already in place, the incremental sales should be brought on close to a 20% incremental margin, versus 8% margin today. Similarly, minimal capital is needed on the balance sheet to grow these brands, making the growth trajectory over the next 3-5 years very ROIC accretive. The stock might look expensive at 20x earnings and 12x cash flow, but the street’s numbers are low by an incremental 10% per year. We're at $5.75 to the Street's $4.25 three years out. We’d buy aggressively on a pullback, but are not so sure that will happen. We think WWW is a double over 2-3 years.

THE SEC & TRADING SUSPENSIONS

The SEC has issued a bulletin explaining Trading Suspensions, available in full here. Here’s a quick takeaway.

Why Suspend Trading?

The SEC has the authority to suspend trading in any stock for up to ten business days for investor protection purposes. The SEC typically suspends trading in a stock where there is:

A lack of information, such as a company that has failed to make required filings,

Questions about the accuracy of information in regulatory filings, press releases and other public information, or

Questions about trading in the stock, including possible insider trading or market manipulation.

What Happens Next?

The expiration of the ten-day suspension is generally not the end of trouble for a company’s shareholders. There is frequently an ongoing investigation into either the company, or into certain holders or traders of the shares, or into brokerage firms that promote or trade the stock. SEC practice prohibits discussing ongoing investigations, and unless there is a formal investigation, with a notification to the subject entities (see last week’s Hedgeye Investing Ideas for the Investing Term: SEC Inquiry) so shareholders may never find out about the investigation until after its results are announced – if at all.

Brokers who wish to trade in the shares for their customers must go through a post-suspension process including an internal compliance review, updated due diligence on the company, and often a regulatory filing through FINRA, the brokerage industry self-regulatory body. Since this filing alerts FINRA that you intend to actively market the now-tainted shares, it is often the equivalent of an engraved invitation for a FINRA letter of inquiry, and perhaps an audit of the firm. This goes a long way towards answering the next question in the SEC’s Bulletin:

If the suspended stock resumes trading, why is it trading at a lower price?

Aside from the taint in the mind of the investing public, brokerage firms are reluctant to put their name alongside that of a stock if they believe there may be a regulatory investigation underway. As we have seen in recent years, fraud investigations often go beyond the civil parameters available to the SEC. No broker wants to put his customers into the stock of a company that might be raided by the FBI.

What About Shareholders?

The SEC is sensitive to the reality that current shareholders of a company will be harmed by a trading suspension. While the suspension is in force, they will not have access to their assets – they can’t liquidate their stock. After the suspension expires, the shares will likely trade at a fraction of the price at which they were bought, and trading is likely to be highly illiquid. The Commission suspends trading only when there is a palpable concern that investors may be making decisions based on incomplete, inaccurate, or deliberately misleading information, or where there is a concern about fraud, or other investor protection concerns that, in the Commission’s estimation, are more compelling going forward than the potential damage to existing shareholders.

Note that a Trading Suspension is not the same as a Trading Halt – which the exchanges impose when there is an order imbalance in a stock during the trading day. Halts can be imposed by the exchanges, or at the request of a company if they are about to release news that management considers likely to have a significant impact on the price of their stock.

News issued in the middle of the trading day can cause pandemonium among shareholders and traders. Unexpected good news – a takeover bid, for example – can cause a feeding frenzy, while unexpected bad news – oops, the merger didn’t go through after all – can cause panic selling. A trading halt can’t prevent outsized moves in the price of a stock, but it dampens volatility and permits market makers to match up orders in a more orderly process.

Conclusion:

Give the SEC credit for trying to educate the individual investor. The more of these releases you read, the better sense you will have of what regulation can, and can not accomplish. If you don’t know what a Trading Suspension is, you should read the SEC release. The Commission thought it important enough that they posted it on Twitter.

In our experience, suspensions generally happen in the stocks of more speculative companies, often stocks you may have bought on a hot tip, or perhaps off a tout sheet from “HOTT STOXX!” that mysteriously appeared in your email in-box. By the time the Commission gets around to suspending trading, the company has probably already done lasting damage to your net worth. People who believe they know which highly speculative stocks are safe to invest in – and that they will be the only ones who know when to get out – remind us of kids who practice jumping out of the way of a speeding locomotive: isn’t it smarter not to play on the tracks in the first place?

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